Historic Fed decision this week

This week, the Fed will decide to start reversing QE at a slow pace of $10B a month. This amount will be increased by $10B every quarter until it reaches $50B. The slow pace of the reversal is a means of control: if markets start selling risk assets at some point, the Fed can always interrupt this move.

The Fed might also eventually lower rates on Excess Reserves, and this would provide banks with liquidity to buy risk assets.

Here is an interesting article regarding the Fed's market control. This article states: The Fed faces "the trade-offs between shrinking the balance sheet and retaining a large portfolio that uses interest on reserves and reverse repos to better control rates."

Note below that Excess Reserves have been increasing in past weeks, which would not be the case if investors really believed in market opportunities. This increase in Excess Reserves probably indicates that banks are afraid of the current valuations of risk assets.

The majority of the 115 sectors that I follow are now in a buy mode (The average number of days until a Buy signal is issued is now negative.)

We can also see that the IWM/SPY ratio has moved in a very tight manner (compared with past trends, which always butted up against the extremes of the envelope.) This indicates a constant supply of money into risk assets, whatever assets. Small caps have been outperforming because they are simply more volatile and hence more responsive to liquidity injections.

This move into risks assets is entirely due to the tax deal that is now expected in a few weeks.

Index investors have also pushed money into equities.

On the currency front, there is a strong negative Euro EV/price divergence and a small positive US$ divergence.

Gold looks weaker by the day.

Conclusions:

US banks still prefer to keep cash in reserves, while foreigners are betting that the Trump tax deal will be good for risk assets.

The QE reversal will only start to matter from mid or end of 2018. This leaves much time for market moves based on external or geopolitical issues.

The tax deal should be positive for the US$ (repatriation of US$) but the re-election of Merkel should be good for the Euro. However, what is known is already priced in.

For now, the best is to trade the small caps: buy when they excessively underperform the large caps and sell/short the opposite situations.